Post #3 — Negative Covenants: How Indentures Protect You From Managerial Value Extraction

Series: How to Read a Bond Indenture — A Value Investor’s Framework

Introduction

Equity investors worry about how management allocates capital.
Bond investors worry about how management extracts capital.

Once you lend money to a company, your upside is capped. Your return is contractual. That means your entire game is about preventing behavior that increases downside. The primary legal tool for that prevention is the negative covenant.

Negative covenants are not technical legal clutter. They are the real economic bargain between you and management. They define what the company is not allowed to do with your money.

If you understand these properly, you can often see credit deterioration before it shows up in financial ratios.

1. What Are Negative Covenants?

Negative covenants are contractual restrictions placed on a borrower. They are designed to stop management from:

Taking on excessive leverage
Encumbering assets with new liens
Selling valuable assets cheaply
Paying shareholders at the expense of creditors
Structurally subordinating existing debtholders

Unlike positive covenants (which require actions), negative covenants prohibit actions unless certain conditions are met.

They exist for one reason only:

To prevent wealth from being transferred from creditors to equity holders.

2. The Core Economic Problem They Solve

Once a company has borrowed money, its incentives change:

Equity benefits from higher volatility
Credit is harmed by higher volatility
Equity prefers leverage
Credit prefers stability
Equity likes buybacks and dividends
Credit prefers retained capital

Negative covenants exist to force management to internalize creditor risk instead of pushing it upward through financial engineering.

Without these protections, a company could borrow safely today and turn reckless tomorrow.

3. The Five Most Important Negative Covenants (Practically Speaking)

These appear in some form in nearly all serious corporate indentures:

1. Limitation on Additional Debt

This limits how much new borrowing the company can take on.

Typical structure:

A fixed leverage ratio
Or a coverage test
Sometimes combined with an absolute dollar cap

Purpose:

Prevents management from layering leverage on top of existing creditors
Stabilizes recovery values in distress

If this covenant is weak, your recovery is not protected from future dilution.

2. Limitation on Liens

Restricts the company’s ability to pledge assets as collateral for new debt.

Why this matters:

Secured debt gets paid before you
If management can freely create new secured debt, your bond silently becomes structurally subordinated

Strong versions:

Require equal and ratable security
Or limit secured borrowing to narrow operational purposes

Weak versions:

Contain broad exceptions labeled “permitted liens”

This is one of the most important protections for unsecured debenture holders.

3. Limitation on Restricted Payments

This governs:

Dividends
Share buybacks
Equity redemptions

In other words: money leaving the creditor ecosystem entirely.

Strong versions:

Tie payments to cumulative earnings
Require solvency tests
Cap payments as a percentage of net income or equity

Weak versions:

Allow payments based on adjusted EBITDA add-backs
Include large “free baskets”

This covenant directly answers one critical question:

Can management pay shareholders while bondholders take the risk?

4. Limitation on Asset Sales

Prevents the company from:

Selling core assets
Divesting profitable units
Spinning off subsidiaries cheaply

Strong versions require:

Fair market value
Cash consideration
Mandatory debt repayment from proceeds

Weak versions:

Allow reinvestment with no paydown requirement
Permit affiliate transactions

This covenant protects the asset base backing your recovery.

5. Limitation on Mergers & Fundamental Changes

Governs:

Mergers
Takeovers
Change of control
Holding company restructurings

Purpose:

Prevents your bond from being silently converted into the debt of a weaker entity
Often includes a Change of Control Put (you get paid at 101–103%)

If this covenant is weak or absent, your counterparty risk can change overnight without your consent.

4. Covenant Loopholes: Where Risk Sneaks In

Most covenant weaknesses enter through three channels:

1. Permitted Baskets

Pre-approved exceptions that allow:

Debt
Liens
Asset transfers
Restricted payments

Large baskets = management flexibility
Small baskets = creditor protection

2. EBITDA Add-Back Games

Companies inflate covenant EBITDA by adding back:

“Non-recurring” costs
Stock compensation
Restructuring expenses

If leverage tests rely on this inflated EBITDA, the protection becomes illusory.

3. Unrestricted Subsidiary Designations

A company can sometimes move assets into an “unrestricted subsidiary” that:

Is not bound by covenants
Can issue debt freely
Can dividend assets away from creditors

This is one of the most dangerous structural loopholes in modern credit documents.

5. How Credit Analysts Actually Use Covenants

Professionals don’t ask:

“Are there covenants?”

They ask:

How tight are the tests?
How fast can they be tripped?
How much soft credit leakage is allowed?
How much financial engineering fits inside the exceptions?

The real value of covenants is not in enforcement after default —
it’s in preemptively constraining management behavior before the balance sheet breaks.

6. Practical Reading Checklist (When You Open an Indenture)

When you scan the covenant section, look for:

Maximum leverage thresholds
Debt incurrence tests
Size and number of “permitted debt” baskets
Whether liens require equal security
What qualifies as a restricted payment
Whether asset sales require mandatory debt repayment
Whether unrestricted subsidiaries are allowed
Whether change of control includes a mandatory repurchase

If more than these feel “loose,” you’re not holding a protected credit instrument you’re holding a volatility exposure with a coupon attached.

7. Why This Matters for Value Investors

For equity investors, value comes from:

High returns on capital
Intelligent reinvestment

For credit investors, value comes from:

Preserving principal
Locking in contractual cash flow
Avoiding silent risk migration

Negative covenants are the control system that makes bond investing analyzable instead of speculative.

Without them, a bond is just:

A fixed return attached to an unpredictable balance sheet.

8. Next in the Series

Post #4 — Call, Put & Redemption Features: How Issuers and Bondholders Trade Optionality

In that post, we’ll analyze:

Call protection
Make-whole premiums
Hard vs soft calls
Change-of-control puts
and how these embed hidden options inside bond pricing.